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Inflation We recognize inflation as the second of the two major macroeconomic problems we can face. The core problems: What kind of price increases are referred to as “inflation”? Who is hurt and who is helped by inflation? What is an appropriate goal for “price stability”? 7-1 Learning Objectives 07-01. Know how inflation is measured. 07-02. Know why inflation is a socioeconomic problem. 07-03. Know the meaning of “price stability.” 07-04. Know the broad causes of inflation. 7-2 Runaway Inflation In 1923 prices in Germany more than doubled every day. No one saved, invested, or made long-run plans. Production came to a halt; unemployment increased by a factor of 10. The economy collapsed. Ultimately Hitler came to power. Zimbabwe experienced a similar economic disaster between 2007 and 2010. 7-3 Exercise The current price of a good is $1. If its price doubles every day, what will its price be in 10 days? 20 days? In 10 days, $512. In 20 days, $524,288. 7-4 What Is Inflation? Inflation: an increase in the average level of prices, not a change in any specific price of a good. The prices of specific basket of goods are collected and computed into an average price level for that basket in a year. A rise in that average price level is inflation. A decrease in that average price level is deflation. 7-5 Relative Prices The market mechanism causes the prices of individual goods and services to rise or fall – an essential market function. Relative price: the price of one good compared to the price of other goods. Buyers switch from one good to another when their relative prices diverge. Inflation is a rise in the average price of all goods. It is not a market function. 7-6 Redistributive Effects of Inflation Inflation makes some people worse off and others better off. There are price effects, income effects, and wealth effects. 7-7 Effects of Inflation Some prices rise and some fall. Rising prices require you to reallocate your purchasing power to ensure that you get the most satisfaction per dollar spent. You might reduce buying goods with higher prices and increase buying goods with lower prices. This can be seen by the difference between nominal income and real income. 7-8 Effects of Inflation Nominal income: the amount of money income received in a given time period, measured in current dollars. Real income: income in constant dollars; nominal income adjusted for inflation. You may get a raise (nominal income increases) – but if it does not rise as fast as inflation, your purchasing power decreases (real income falls). 7-9 Redistribution of Income and Wealth by Inflation Price effects. Those who buy products that are increasing in price the fastest end up worse off. Those who sell products that are increasing in price the fastest end up better off. Those who buy products that are increasing in price the slowest end up better off. Those who sell products that are increasing in price the slowest end up worse off. 7-10 Redistribution of Income and Wealth by Inflation Income effects. People with nominal incomes rising more slowly than inflation end up worse off. People with nominal incomes rising faster than inflation end up better off. 7-11 Redistribution of Income and Wealth by Inflation Wealth effects. Those who own assets that are declining in real value end up worse off. Those who own assets that are increasing in real value end up better off. 7-12 Money Illusion Money illusion: using nominal dollars rather than real dollars to gauge changes in one’s income or wealth. Exercise: In the “good old days” a movie ticket was 50 cents and the minimum wage was $1.00. Compare the purchasing power of the minimum wage today to the “good old days.” You could buy two movie tickets with one hour’s work before, but not now. 7-13 Exercise in Money Illusion The inflation rate in 1980 was 13.5%. In 1979 your income was $10,000. In 1980 your income was $11,000. Did your purchasing power increase? Decrease? Stay the same? Decrease! Your income went up 10% while prices went up 13.5%. 7-14 Macro Consequences of Inflation Uncertainty: not knowing the prices of goods in the future makes purchasing and production decision making much more difficult. Speculation: decisions will shift from standard economic activity to betting on the future prices of goods. Bracket creep: in a progressive tax system, when nominal incomes rise, the taxpayer gets pushed into a higher tax bracket. 7-15 Hyperinflation Hyperinflation: inflation rate in excess of 200 percent, lasting at least 1 year. Spending accelerates and production declines. 7-16 Deflation Deflation: a general decrease in average prices. This has redistribution effects that are just the opposite of those for inflation. This has macro consequences also. Sellers are reluctant to stock inventory. Buyers are reluctant to buy now. Businesses are reluctant to borrow funds or invest. Incomes fall, and asset values decrease. 7-17 Measuring Inflation Measuring inflation serves two purposes. Gauging the average rate of inflation. Identifying its principal victims. 7-18 Consumer Price Index (CPI) Consumer price index (CPI): a measure (index) of the average price of consumer goods and services. Used to calculate the inflation rate. Inflation rate: the annual percentage rate of increase in the average price level. 7-19 Creating a Price Index Select a “market basket” of goods: a standardized list of goods and services customers usually buy. Select a base year: the reference year whose dollar value will be used. Set the price index in the base year always equal to 100. Measure the prices for the basket of goods in both the current year and in the base year. 7-20 Computing a Price Index Price index in current year Price index base year Basket price in the base year = $6,000. Basket price in the current year = $6,600. Compute the price index (CPI) for the current year: = Basket price in current year Basket price in base year X/100 = $6,600/$6,000 X = (6,600 x 100)/6,000 X = 110 CPI in the current year is 110. A CPI of 110 indicates that prices in the current year are 10% higher than prices in the base year. 7-21 Exercise In 2006 CPI was about 200.* • * 1983 was the base year. In 1983 CPI was about 100.* These two CPI figures tell us that prices doubled between 1983 and 2006. In 1974 CPI was about 50.* So prices doubled between 1974 and 1983. If a good was priced at $10 in 1974, what would you expect the price to be in 2006? 7-22 Other Measures of Inflation Core inflation: changes in CPI, excluding food and energy prices. Producer price index (PPI): changes in the average prices at intermediate steps of production. GDP deflator: changes in prices of all goods and services included in GDP. Used to correct nominal GDP to real GDP. 7-23 Computing Inflation Rate from CPI Inflation rate = CPI year 2 – CPI CPI CPI in 2006 was 201.6. CPI in 2005 was 195.3. Compute the inflation rate for 2006: Inflation rate = (201.6-195.3)x100/195.3 3.23% year 1 X 100 year 1 = 7-24 The Goal: Price Stability Price stability: the absence of significant changes in the average price level. Officially defined as a rate of inflation of less than 3 percent. Established by Full Employment and Balanced Growth Act of 1978. 7-25 The Goal: Price Stability Measurement concerns. We are seeking price stability at the lowest rate of unemployment. From year to year, there are quality improvements in the basket of goods. New products change the content of the basket of goods we buy. 7-26 The Historical Record highest lowest The highest and lowest annual inflation rates since WW2 are identified. 7-27 Causes of Inflation Demand-pull inflation: results from excessive pressure to buy on the demand side of the economy. A booming economy creates shortages. Too much money pumped into the economy by the Federal Reserve. Cost-push inflation: due to higher production costs putting pressure on suppliers to push up prices. 7-28 Protective Mechanisms Cost of living allowances (COLA): nominal incomes are indexed to automatically rise at the same rate as inflation. Adjustable-rate mortgage (ARM): interest rate on a mortgage rises along with inflation so that lenders do not lose money. 7-29 The Real Interest Rate Real interest rate: the nominal interest rate minus the anticipated inflation rate. The borrower pays the nominal rate. The inflation-adjusted (real) rate of interest: Real interest rate = Nominal interest rate – Anticipated rate of inflation Protects the lenders. Hurts the borrowers. Borrowers will pay back loan using more lower-valued dollars, but lenders receive the same purchasing power. 7-30 The Economy Tomorrow The virtues of inflation. A little inflation might be a good thing. The challenge for tomorrow is to find the optimal rate of inflation. High enough to encourage more spending. Low enough not to raise the specter of an inflationary flashpoint. Inflationary flashpoint: the rate of output at which inflationary pressures intensify. 7-31 Revisiting the Learning Objectives 07-01. Know how inflation is measured. Inflation is measured by changes in a price index such as the consumer price index (CPI). 7-32 Revisiting the Learning Objectives 07-02. Know why inflation is a socioeconomic problem. Inflation redistributes income by altering relative prices, income, and wealth. Some people actually gain from inflation, whereas others suffer a loss of real income or wealth. Inflation creates uncertainty and speculation and detracts from productive activity. COLAs and ARMs help protect some people from inflation. 7-33 Revisiting the Learning Objectives 07-03. Know the meaning of “price stability.” The U.S. goal is an inflation rate of less than 3 percent per year. This goal must be integrated with a potentially conflicting goal of full employment. 7-34 Revisiting the Learning Objectives 07-04. Know the broad causes of inflation. Inflation is caused either by excessive demand (“demand-pull” inflation) or by structural changes in supply (“cost-push” inflation). 7-35
